What Is the Marginal Revenue and Why Is It Important?
Understand marginal revenue and its critical role in optimizing business strategy and maximizing profitability.
Marginal revenue is a fundamental concept in business and economics that helps determine the profitability of selling additional units of a product or service. It provides insights into how a company’s total income changes as its sales volume increases. This metric is important for making informed decisions about production levels, pricing strategies, and overall business growth.
Understanding Marginal Revenue
Marginal revenue refers to the additional total revenue a business generates by selling one more unit of a good or service. This concept highlights the incremental financial gain associated with expanding sales. It is a dynamic measure, meaning its value can change with each additional unit sold, reflecting the fluctuating market conditions and consumer demand.
The amount of marginal revenue can be positive, negative, or zero. Positive marginal revenue indicates that selling an additional unit increases total revenue, while negative marginal revenue means total revenue decreases. When marginal revenue is zero, selling an additional unit does not change total revenue.
Calculating Marginal Revenue
Calculating marginal revenue involves determining the change in total revenue divided by the change in the quantity of units sold. The formula is expressed as: Marginal Revenue = (Change in Total Revenue) / (Change in Quantity). This calculation helps a business understand the precise revenue contribution of each additional unit.
To illustrate, consider a small business that sells custom-made t-shirts. If the business sells 100 t-shirts at $20 each, its total revenue is $2,000. If it then sells 101 t-shirts, and the total revenue becomes $2,015, the change in total revenue is $15 ($2,015 – $2,000). The change in quantity is 1 t-shirt (101 – 100).
Using the formula, the marginal revenue from selling the 101st t-shirt is $15 ($15 / 1 unit). This means that the sale of that single additional t-shirt contributed $15 to the company’s total revenue.
Marginal Revenue and Business Strategy
Understanding marginal revenue helps businesses as it directly influences production and pricing decisions. Companies use this metric to identify the optimal level of output that maximizes profit. The general rule for profit maximization suggests that a business should continue to increase production as long as marginal revenue is greater than marginal cost.
Profit maximization occurs when marginal revenue equals marginal cost. At this specific output level, the revenue generated from selling one additional unit precisely covers the cost of producing that unit. If marginal revenue falls below marginal cost, producing additional units would lead to a decrease in overall profit, indicating that production should be halted or reduced.
Marginal Revenue’s Relationship with Demand and Total Revenue
Marginal revenue has a direct relationship with both the demand curve and total revenue. As a business sells more units, it often needs to lower the price to attract additional buyers, especially in markets that are not perfectly competitive. This need to reduce prices for increased sales typically causes marginal revenue to decline as more units are sold.
Graphically, the marginal revenue curve is downward sloping and lies below the demand curve. This occurs because to sell an extra unit, the price must be lowered not just for that unit, but often for all units sold, which reduces the additional revenue gained. The point where marginal revenue becomes zero indicates the quantity at which total revenue is maximized. Beyond this point, selling more units would lead to a decrease in total revenue, as the revenue lost from price reductions on existing units would outweigh the gains from new sales.